The risks a business faces can be diverse, complex and ever changing. Fundamentally, all business risks must relate to threats to an organisation's financial well being. These threats can be divided into the three main categories of market, credit and operational risks: -
Market risks - relating to variations in the value of financial contracts. Whatever is being traded, the final focus of market risk is on obligations traded in financial markets - including the impact on business performance resulting from price fluctuations. Key areas for business are the value of stock (equity value), interest and exchange rates, commodity prices and indices of the major financial markets - see figure 1, below.
Figure 1: Market risks and instruments
Credit risk - relating to the possibility that parties in any financial transaction fail to fulfil their obligations and honour their debts. Most businesses, whether in the financial markets or not, extend credit in some form to their customers. The effective management of credit risk is essential for all organisations.
Derivatives are a special form of credit risk, often used to offset other risks (hedging), or to make profits by exploiting anomalies in markets (arbitrage). Speculators use these instruments to undertake risk deliberately. Organisations trading in derivatives have to understand fully the risks involved, which perhaps go beyond those of other forms of credit.
Operational risk - associated with the activity of the organisation - see fig 2. Recently this has become an all-embracing term covering all risks that are not strictly market or credit related. Many new and emerging risk issues will be categorised in this area, including some that are difficult to identify and the outcomes of which may not fully understood. Operational risks are some of the most problematic and difficult to deal with, and have been responsible for some spectacular business failures in recent years.
Figure 2: Categories of operational risk
Conventionally risks have been managed as if they could all be identified and measured. So insurance decisions are made on the basis of actuarial calculations and historical data. The military carried out much work on the analysis and development of systems for operational risk management. Organisations involved with the creation and disposal of nuclear waste and hazardous chemical and biological material developed risk management techniques focused on safety. Portfolio managers evolved their systems based on Markov's Portfolio Theory, fashioned in the 1950's. Financial institutions have always seen credit risk management as a core competence and a variety of mathematical and statistical techniques for understanding risk have evolved. These include variance/co-variance measures, Monte Carlo simulation and 'worst case scenario modelling'.
Figure 3: Risks to the organisation (after Financial Times, 2000)
Copyright Partnership Sourcing Ltd 2001. All rights reserved.